Paying people to break windows

The "Greek debt crisis" and its implications for Europe's monetary union continue to dominate global financial markets. Here are some excerpts from an AP article posted on Monday, with our comments shown in brackets:

"Chancellor Angela Merkel's Cabinet approved legislation on Monday that would give Greece euro22.4 billion ($29.6 billion) over three years as part of a wider bailout, as the German government acknowledged that letting Greece go bankrupt could send the euro into a tailspin and hurt Germany's own economy. "It doesn't only mean that we help Greece, but that we stabilize the euro as a whole, which helps people in Germany," said Merkel..."

[In the latest Weekly Update we said that the European leaders of the countries that are agreeing to provide the bailout funds for Greece's bondholders could perhaps weather the current political storm by assuring voters that a crisis will be averted. Angela Merkel is clearly taking that approach when she says, "It doesn't only mean that we help Greece, but that we stabilize the euro as a whole, which helps people in Germany". The question we had (and have) was: What are they going to say after they have used tens of billions of euros of their own taxpayers money to mitigate the losses of Greece's bondholders and the crisis continues to grow? Will they be prepared to commit political suicide by suggesting that even more of their own country's wealth be sent to Greece? Or Portugal? Or Spain? There's a good chance that this question will have to be answered within the next 6 months, because even if the bailout funds are made available to the government of Greece the situation won't be improved beyond the short-term.]

"The European Central Bank, meanwhile, suspended its rating limits on Greek debt."

[This makes it clear that when 'push comes to shove' the ECB will be just as willing as the Fed to degrade its own balance sheet in the hope of maintaining confidence in a failed system.]

"Both moves came after European governments and the International Monetary Fund agreed Sunday to give euro110 billion ($145 billion) in loans to Greece over three years. The loans came after Athens adopted a new round of austerity measures that provoked fresh uproar among Greek workers."
"Greece announced more austerity measures on Sunday worth euro30 billion ($40 billion) through 2012 -- including public service and pension pay cuts and higher taxes."

[There is considerable doubt regarding the ability of the Greek government to implement the promised "austerity measures". What will happen if these measures prove to be politically impossible? Will the "bailout" funds still be provided to Greece by Germany et al at the risk of an even greater political backlash from the German voting public, or will default then become the only option?]

"Greece's new austerity measures are expected to exacerbate its recession, but the massive rescue plan will include euro10 billion ($13.3 billion) for a "stabilization fund" to support Greek banks, Greece's Deputy Finance Minister Philippos Sachinidis told state television on Monday."

Apparently, the "stabilization fund" to support Greek banks could be as much as 20 billion euros. Greek banks are in trouble in part because they hold a lot of Greek government debt. So, what we now have is the Greek government borrowing money to support banks that are failing partly because they loaned money to the Greek government. It doesn't get any more absurd than this.

The news flow and the obvious absence of a viable management plan from Europe's political leadership have extended the euro's decline and caused the Dollar Index to break decisively above its recent highs. The price action suggests a short-term target of around 85 for the Dollar Index, but the currency market is almost completely news-driven at this time and the picture painted by the news is changing on a daily (and sometimes hourly) basis.

It is not just the currency market that has been affected by the latest developments in the government debt crisis. Also of significance is that the S&P500 Index closed below support at 1180 on Tuesday, thus providing the first clear evidence of a trend change from up to down. Importantly, the stock market's break below support was confirmed by a meaningful widening of credit spreads.

We previously mentioned that the likely pattern once a top is in place would entail a sharp initial decline followed by a rebound to 'test' the peak. The sharp initial decline appears to be underway and probably has more to go.

The gold price was down $14 on Tuesday, but on the chart this looks like nothing more than a routine pullback to 'test' last week's upside break through resistance in the low-$1160s. Moreover, the major gold stocks held up very well on Tuesday in the face of general equity-market turmoil.

In saying this we may be guilty of 'jumping the gun', but there now appears to be sufficient understanding that gold will ultimately benefit in a big way from the government debt crisis to prevent gold-related investments from being taken down in sympathy with industrial-commodity-related investments.